The cryptocurrency industry last week experienced a turbulence long predicted by industry observers.  The third largest stablecoin, TerraUSD (“UST”), lost its one-to-one peg to the U.S. dollar about 10 days ago, trading well below 10 cents per UST by 11:00 AM EST on May 16.  The sister token (“Luna”)—meant to stabilize UST—lost all of its value as well and fell from a high of around $116 per Luna to a fraction of a penny.

In response to the drop, validators on the Terra chain ceased validating new transactions of UST or Luna for 9 hours, and most of the exchanges delisted or suspended trading.[1]  On top of the broad equity market downward pressure, the near collapse of UST contributed to a loss of over 20% of the total cryptocurrency market cap.

UST is an algorithmic stablecoin, which is designed to maintain the peg of its value to the U.S. dollar (or some other fiat currency) on a one-to-one basis using an algorithm rather than a reserve of assets (i.e., Circle (“USDC”) and Tether (“USDT”) are backed by cash and short-term U.S. government securities).  Generally, stablecoins are used for fast trading on centralized and decentralized exchanges.  Crypto asset traders use stablecoins to trade between crypto assets and with fiat assets.  Stablecoins have also been used for yield farming, lending, and other uses.

In the past, many algorithmic stablecoins have launched and failed.  For example, Iron Finance’s stablecoin IRON lost its value in a matter of days and wiped out more than $2 billion in market value in June of 2021.  UST was launched in 2020 and prior to its collapse had grown to a market cap of over $18 billion.[2]

Differing explanations have been given for the sudden collapse of UST.  One is that over 80% of outstanding UST had been locked in a sister protocol—Anchor—which promised to pay approximately 20% interest per year on any locked UST.  When a large amount of UST was withdrawn from Anchor in a short period of time, the market lost trust in the UST-Luna architecture, leading to further withdrawals of UST and an unpegging.  Luna was minted to stabilize the UST price, flooding the market with Luna tokens and further destabilizing the token.

The downward spiral occurred despite an emergency effort by Luna Foundation Guard—a Swiss foundation formed by Terraform Labs that developed Luna and UST—to utilize a reserve fund of about $3.5 billion worth of Bitcoin (“BTC”) and other cryptocurrencies to maintain the peg for UST.  The effort briefly restored the value of UST to about 90 cents, but ultimately failed.

A second, more theoretical explanation is that any value stabilizing algorithm is unsustainable for an extended period of time, and especially vulnerable to significant market stress.  While a sister token like Luna can be minted or burned to defend the peg, it has no intrinsic value, and therefore ultimately susceptible to a loss in consumer trust.

The sudden loss of value has renewed calls for regulation of stablecoins in the United States and the EU. While reserve-backed stablecoins such as USDC or USDT can be required to disclose the amount, types and location of reserve assets, it is not clear how agencies will approach regulating algorithmic stablecoin. We will summarize recent legal developments in an upcoming blog post.

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[1] WSJ, “Stablecoin TerraUSD Continues Downward Spiral; Bitcoin Gains,” (Mar. 13, 2022), available here.

[2] WSJ, “Why Did Cryptocurrencies TerraUSD and Luna Unravel? Stablecoin Price Crash Explained,” (Mar. 13, 2022), available here.

Byungkwon Lim
Author

Byungkwon Lim, a member of the firm’s Corporate Department, leads the firm’s Derivatives, Blockchain and Hedge Fund Practice Groups. Mr. Lim advises a wide range of clients, including banks, other dealers and end users, on derivatives regulatory matters and transaction structuring. In the blockchain space, Mr. Lim advises technology companies and developers on regulatory matters, platform structuring and offering and related documentation. Mr. Lim also represents advisers to hedge funds and managed accounts in connection with the structuring, offering and operation of such vehicles and accounts.

Author

Amy Aixi Zhang is a corporate associate and a member of Debevoise's Banking and Financial Institutions Groups. She graduated from Harvard Law School in 2020. During her time in law school, Ms. Zhang was President and Co-Founder of the Harvard Law School Blockchain and FinTech Initiative. She authored “Regulating Crypto Assets: Securities and Commodities,” a case study published in FinTech Law: The Case Studies by Harvard University Press in July 2020 and was a fellow at a mortgage servicing fintech company before joining Debevoise in 2020. She can be reached at aazhang@debevoise.com.